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# Chapter 3 Financial Analysis

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Chapter 03: Financial Analysis

## Financial Analysis

3. Profitability ratios (LO2) Polly Esther Dress Shops, Inc., can open a new store that will do an annual sales volume of \$960,000. It will turn over its assets 2.4 times per year. The profit margin on sales will be 7 percent. What would net income and return on assets (investment) be for the year?

#### Polly Esther Dress Shops, Inc. 14. Du Pont system of analysis (LO3) The King Card Company has a return-on-assets (investment) ratio of 12 percent.

a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity?

b. If the firm had no debt, what would the return-on-equity ratio be?

#### King Card Company

a. b. The same as return on assets of 12% because with no debt, the denominator would be 1.

15. Du Pont system of analysis (LO3) Using the Du Pont method, evaluate the effects of the following relationships for the Lollar Corporation.

1. Lollar Corporation has a profit margin of 5 percent and its return on assets (investment) is 13.5 percent. What is its assets turnover ratio?

2. If the Lollar Corporation has a debt-to-total-assets ratio of 60 percent, what would the firm’s return on equity be?

3. What would happen to return on equity if the debt-to-total-assets ratio decreased to 40 percent?

#### Lollar Corporation

a. b. 3-15. (Continued)

c. 18. Average collection period (LO2) A firm has sales of \$1.2 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is \$180,000. What is the average collection period?
(Use a 360-day year.)

#### 3-18. Solution: 19. Average daily sales (LO2) The Chamberlain Corporation has an accounts receivable turnover equal to 12 times. If accounts receivable are equal to \$90,000, what is the value for average daily credit sales?

#### Chamberlain Corporation To determine credit sales, multiply accounts receivable by accounts receivable turnover.  1. Trend analysis (LO4) Jodie Foster Care Homes, Inc., shows the following data:

Year Net Income Total Assets Stockholders’ Equity Total Debt

2007 \$118,000 \$1,900,000 \$ 700,000 \$1,200,000

2008 131,000 1,950,000 950,000 1,000,000

2009 148,000 2,010,000 1,100,000 910,000

2010 175,700 2,050,000 1,420,000 630,000
a. Compute the ratio of net income to total assets for each year and comment on the trend.

b. Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b.

#### 3-27. Solution:

Jodie Foster Care Homes, Inc.

a. 2007 \$118,000/\$1,900,000 = 6.21%

2008 \$131,000/\$1,950,000 = 6.72

2009 \$148,000/\$2,010,000 = 7.36

2010 \$175,700/\$2,050,000 = 8.57

Comment: There is a strong upward movement in return on assets over the four year period.

b. 2007 \$118,000/\$700,000 = 16.86%

2008 \$131,000/\$950,000 = 13.79

2009 \$148,000/\$1,100,000 = 13.45

2010 \$175,700/\$1,420,000 = 12.37

Comment: The return on stockholders’ equity ratio is going down each year. The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt.

3-27. (Continued)

Optional: This can be confirmed by computing total debt to total assets for each year. 2007 63.2%

2008 51.3

2009 45.3

2010 30.7

1. Trend analysis (LO4) Quantum Moving Company has the following data. Industry information also is shown.

Industry Data on

Company Data Net Income/Total Assets
Year Net Income Total Assets

2008 \$350,000 \$2,800,000 11.5%

2009 375,000 3,200,000 8.4

2010 375,000 3,750,000 5.5

Industry Data on

Year Debt Total Assets Debt/Total Assets

2008 \$1,624,000 \$2,800,000 54.1%

2009 1,730,000 3,200,000 42.0

2010 1,900,000 3,750,000 33.4

As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of:

a. Net income/Total assets.

b. Debt/Total assets.

#### 3-28. Solution:

Quantum Moving Company

a. Net income/total assets

 Year Quantum Ratio Industry Ratio 2008 12.5% 11.5% 2009 11.7% 8.4% 2010 10.0% 5.5%

Although the company has shown a declining return on assets since 2008, it has performed much better than the industry. Praise may be more appropriate than criticism.

3-28. (Continued)

b. Debt/total assets

 Year Quantum Ratio Industry Ratio 2008 58.0% 54.0% 2009 54.1% 42.0% 2010 50.7% 33.4%

While the company’s debt ratio is declining, it is not declining nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise.

35. Using ratios to construct financial statements (LO2) The following information is from Harrelson, Inc.’s, financial statements. Sales (all credit) were \$20 million for 2010.
Sales to total assets 2 times

Total debt to total assets 30%

Current ratio 3.0 times

Inventory turnover 5.0 times

Average collection period 18 days

Fixed asset turnover 5.0 times

Fill in the balance sheet:
Cash ______ Current debt ______

Accounts receivable ______ Long-term debt ______

Inventory ______ Total debt ______

Total current assets ______ Equity ______

Fixed assets ______ Total debt and equity ______

Total assets ______

#### 3-35. Solution:

Harrelson Inc.

Sales/total assets = 2

Total assets = \$20 million/2

Total assets = \$10 million

Total debt/total asset = 30%

Total debt = \$10 million x .3

Total debt = \$3 million

Sales/inventory = 5.0x

Inventory = \$20 million/5x

Inventory = \$4 million

Average daily sales = \$20 million/360 days

= \$55,555.55 per day

Accounts receivable = 18 days × \$55,555.56

= \$1 million (or)

3-35. (Continued) Fixed assets = \$20 million/5x

= \$4 million

Current assets = Total assets – Fixed assets

= \$10 million - \$4 million

= \$6 million

Cash = Current assets – accounts receivable –

inventory

= \$6 million – \$1 million – \$4 million
= \$1 million
Current liabilities = Current assets/3

= \$6 million/3

= \$2 million

Long-term debt = Total debt – current debt

= \$3 million – \$2 million

= \$1 million

Equity = Total assets – total debt

= \$10 million – \$3 million

= \$7 million

3-35. (Continued)

 Cash................ \$ 1.0 million Current debt............. \$ 2.0 million Accounts receivable..... \$ 1.0 Long-term debt............. \$ 1.0 Inventory......... \$ 4.0 Total debt....... \$ 3.0 Total current assets............ \$ 6.0 Equity............. \$ 7.0 Fixed assets..... \$ 4.0 Total assets..... \$10.0 million Total debt and equity........... \$10.0 million

36. Comparing all the ratios (LO2) Using the financial statements for the Snider Corporation, calculate the 13 basic ratios found in the chapter.

SNIDER CORPORATION

Balance Sheet

December 31, 2010

Assets

Current assets:

Cash \$ 50,000

Marketable securities 20,000

Accounts receivable (net) 160,000

Inventory   200,000

Total current assets \$430,000

Investments 60,000

Plant and equipment 600,000

Less: Accumulated depreciation (190,000)

Net plant and equipment    410,000

Total assets \$900,000

Liabilities and Stockholders’ Equity

Current liabilities

Account payable \$90,000

Notes payable 70,000

Accrued taxes      10,000

Total current liabilities 170,000

Long-term liabilities:

Bonds payable 150,000

Total liabilities \$320,000

Stockholders’ equity

Preferred stock, \$50 per value 100,000

Common stock, \$1 par value 80,000

Capital paid in excess of par 190,000

Retained earnings   210,000

Total stockholders’ equity 580,000

Total liabilities and stockholders’ equity \$900,000

 SNIDER CORPORATION Income statement For the Year Ending December 31, 2010 Sales (on credit) \$1,980,000 Less: Cost of goods sold 1,280,000 Gross profit 700,000 Less: Selling and administrative expenses 475,000* Operating profit (EBIT) 225,000 Less: Interest expense 25,000 Earnings before taxes (EBT) 200,000 Less: Taxes 80,000 Earnings after taxes (EAT) \$ 120,000

*Includes \$35,000 in lease payments.

#### 3-36. Solution:

Snider Corporation

Profitability ratios

Profit margin = \$120,000/\$1,980,000 = 6.06%

Return on assets (investment) = \$120,000/\$900,000 = 13.3%

Return on equity = \$120,000/\$580,000 = 20.69%

Assets utilization ratios

Receivable turnover = \$1,980,000/\$160,000 = 12.38x

Average collection period = \$160,000/\$5,500 = 29.09 days

Inventory turnover = \$1,980,000/\$200,000 = 9.9x

Fixed asset turnover = \$1,980,000/\$410,000 = 4.83x

Total asset turnover = \$1,980,000/\$900,000 = 2.2x

Liquidity ratio

Current ratio = \$430,000/\$170,000 = 2.53x

Quick ratio = \$230,000/\$170,000 = 1.35x

Debt utilization ratios

Debt to total assets = \$320,000/\$900,000 = 35.56%

Times interest earned = \$225,000/\$25,000 = 9x

Fixed charge coverage = \$260,000/\$60,000 = 4.33x

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